SECURITIES AND ~~~EXCHANGE COMMISSION ~\:~~\~

Washington, D. C. 20549 • ~ ..tiJ(202) 272.-2650 C8~~

Remarks toAssociation of Bank Holding Companies

Mayflower HotelWashington, D.C.

November 13, 1980

"Investment Management and the Glass-Steagall Act --The Emperor's New Clothes"

Stephen J. Friedman, Commissioner

Evolution in the financial markets has outpaced our

regulatory structure in form and in concept. I have elsewhere

examined the implications of these changes for government

regulators. Today, I would like to discuss another aspect

of the impact of this evolution: the Glass-Steagall Act

and, in particular, its application to investment managementby banks.

It is very plain that the financial markets have changed

so much that it is no longer possible to deal with the question

of bank securities activities by simply invoking the talisman

that Congress decided in 1933 to separate commercial bankingand investment banking.

The lines drawn by the Congress in the Glass-Steagall

Act zigged and zagged, and the result has shaped the banking

industry. The internal contradictions of the compromises of

1933 -- for example, the decision not to separate commercial

banking and trust activities, and the fact that banks may

both invest in and underwrite municipal general obligation

bonds, but may only invest in municipal revenue bonds --

have come to haunt the defenders of those boundary lines.

Those contradictions, coupled with the development of new

services and instruments by all intermediaries in the

financial markets, mean that some, but by no means all, of

the boundary lines may no longer serve any meaningful public

policy function -- although they still have important competi-

tive consequences.

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In the area of investment management, these 'developmentsraise a number of questions:

- should banks and savings institutions continue'to be excluded from mass-merchandised commingledinvestment vehicles?should bank investment management activitiescontinue to be excluded from so much of theFederal securities laws?

I should emphasize at the outset that these are personalviews. They do not reflect either th~ deliberations orjudgments of my fellow Commissioners.

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Why Revisit the Glass-Steagall Act?Before looking more closely at bank investment management,

I want to make a few general observations about the Glass-SteagallAct. The securities markets are healthy. There is plentyof competition. In that case, why should the Congress devotetime and attention to the Glass-Steagall Act?

The growing disjunction between the assumptions thatunderly the Glass-Steagall Act and the facts of financial lifecannot be ignored. It simply will not do to say that the .'.system is working just fine now and that there is no compellingneed for change. The system may be working, but it is notworking the way the Congress envisioned in 1933. It is notso much that the Act's prohibitions have been evaded butrather that in some cases they have been overtaken by events.If we fail to face these changes squarely, then we shall becarried along on the wave of change. If the markets are notstructured by action of the Congress, they will be structuredby market forces.

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We should not sit idly by and watch the markets effectregulatory change for no better reason than that our memoryof the vulnerability of the banking system has dimmed.Unless we act consciously, we may lose through inactionparts of the Glass-Steagall concept that have continuingvitality, preserving only regulatory remnants whose onlyfunction is to protect market participants against competition.Indeed, the Congress has begun to come to grips with theconsequences of change outside of the Glass-Steagall area.Recent legislation expanding the asset and liability powersof thrift institutions and extending reserve requirementsto nonmembers of the Federal Reserve are good examples.

To say that Congressional attention is required is justthe beginning of the inquiry. Wholesale reconsiderationof the Glass-Steagall Act would be a very ambitious project ineconomic planning. One cannot review the Glass-Steagall Actin isolation. The Bank Holding Company Act, The FederalReserve Act, deposit interest rate controls, and the securitieslaws and others must also be considered. I distrust ourability to do intelligent planning on such a grand scale.Thus, I do not believe it is wise to attempt the often-suggested "full-scale review of the Glass-Steagall Act."Rather, we should lower our sights a bit, recognize that thefundamentals of the system have served us well not onlysince 1933, but for over two centuries, and focus our energieson making the necessary adjustments to deal with changes asthey force their attention upon us.

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At the same time, it would be a terrible mistake to

look at each issue through a microscope, tacitly assuming

that each bite is so small that we need not pay attention to

its larger consequences. There are public policy considera-

tions in the current Glass-Steagall debate of great current

importance, and they should be faced squarely. Moreover,

they may well lead to different results in different aspects

of this inquiry. For example, in my judgment the question

of bank underwriting of commercial paper raises quite different

problems from the question of investment management.

The Major Questions.What is required, I think, is an identification of-the

major questions that bear on Glass-Steagall issues, and

a thorough exploration of those questions by the Congress.

Then Glass-Steagall issues can be examined against that

background. I would think that the following considera-

tions, among others, would be relevant.

Bank power. Is there a reason to be concerned aboutthe power of large banks? Are the financial marketsgrowing more or less concentrated? In what geographicaland sectoral markets should that question be examined:state, national or international? What is the signifi-cance of the fact that banks account for a diminishingshare of our financial assets? Is there evidence ofabuse of the power that large banks possess?, If so,how do those concerns relate to specific Glass-SteagallAct questions, such as investment management?

The experience of the last 45 years. What securi-ties activities are banks actively performing? Someof these activities were explored in a study conducted afew years ago by the staff of the SEC. What does ourexperience with these and other bank and bank holdingcompany activities teach us about whether this conductraises the dangers that concerned the Congress in1933? What does it tell us about whether fair com-petition between banks and nonbanks is possible?

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Incremental risks. To what extent would any givenextension of bank securities activities pose risks thatdo not exist in already permitted activities? If theyare not great, but the concerns endure, should thepermissible scope of bank securities activities benarrowed?

Securities regulation. What are the consequences ofnot regulating bank investment management and securitiesactivities under the securities laws? Is there anycontinuing justification for treating bank securitiesactivities as "banking" when they are doing virtuallythe same thing as securities firms?

Changes in bank regulation. The structure and natureof bank regulation has changed dramatically since1933. The Glass-Steagall Act was motivated in sub-stantial part by concerns about bank safety andsoundness. To what extent have the subsequentregulatory changes ameliorated some of the originalconcerns?

Conflicts of interest and the usefulness of ChineseWalls. How successful is the Chinese Wall mechanism,which has been used so extensively to deal with theconflict-of-interest and inside information problemsinherent in the combination of commercial bankingand trust activities?

Development of unregulated intermediaries. Theexplosion of nonbank intermediaries and nonbanklenders suggests that, if the Glass-Steagall Act'sconcerns endure, then the focus may be too narrow.Why bar securities activities to bank holdingcompanies but not to sponsors of money market fundsand insurance companies? There may be good reasonsto make those distinctions, but they require a contem-porary explication.

The advantages of segregated markets. One of theconsequences of an enforced separation betweeninvestment and commercial banking is pressure in eachmarket to innovate in order to compete with the other.The development of the commercial paper market is agood example of the beneficial aspects of bifurcatedmarkets. What are the lessons of that experience forthe Glass-Steagall Act?

The experience of other countries. Other economiesstructure their financial markets in very differentways. Germany and Canada come quickly to mind.Recognizing the cultural and historical differencesthat these institutions reflect, what are the lessonsof those economies for our inquiry?

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-6-- Impact on the pricing and distribution mechanism.

To what extent would further growth in the banks'market share of securities activities affect thepricing and d~stribution mechanisms? Assumingthat a banking system as broad and as concentratedas those in Canada and Germany would drasticallydecrease the number of decision-makers and theliquidity of the markets, is that the likely resultof further deregulation in banking? Could some ofthese concerns be met by releasing some of the con-straints on classical banking while buttressingthe separation of banking from other sectors ofthe financial markets? Is that alternative realistic?

Investment ManagementLet us look at some of these considerations in the context

of investment management by banks. In the first twenty yearsof this century, the investment management activities of bankswere largely confined to traditional personal trust services~As the financial excesses of the Twenties wore on, the securi-ties affiliates of banks were drawn to the formation ofinvestment companies. But banks were not a major factorin investment company growth, and their investment managementactivities were not at the core of the problems that prooucedthe Glass-Steagall Act. Indeed, the laws adopted in 1940 toregulate investment management assumed that the basic rela-tionship was between market professionals and individuals;and the trust departments of banks were largely exempted inlight of extensive bank regulation and common law fiduciaryobligations.

Since that time, there has been a revolution in theinstitutionalization of private savings. Institutional tradingon the New York Stock Exchange was recently reported to havereached the 70% level. Between 1960 and 1978 alone, the value

-7-of the assets of private noninsured pension funds rose from$6.5 billion to over $200 billion. Life insurance companiesmanaged an additional $120 billion in pension reserves atthe end of 1978. In contrast, the assets managed by mutualfunds, which in 1940 were assumed to represent the prototypicalpattern, peaked in 1975 at about $55 billion until the 'explosivegrowth of money market funds in the late 1970s, which boo~tedthe total to about $95 billion in 1979.

The social concerns of the Great Depression have resultedin an enormous new class of customers for investment advisoryservices -- trusts established to fund employee pension,

<profit-sharing and other benefit plans. From the start, thecommercial banks were in a good position to exploit tne eme~ging

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market. In their traditional role as'individua~ and corporateI ,

trustee, they were prepa~ed to provide both inv~~t~ent' adviceand operational services for independent trust~~s as employeebenefit plans grew. They were able to'expand their existing

. . .customer relationships, mass merchandising skills, 'dat~, .processing and telecommunications capabilities to offer a

-sophisticated full line of servic~s. Today, the .rang~.ofinvestment advisory services offered by commercial banksand their holding companies is wide:

individual voluntary and automatic investment plansindividual and pooled trust accountsseparate and commingled employee ben~fit plantrustsindividual agency accountspooled trust accounts funding individuai~ HR-10 andindividual retirement plans

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Cohsider now the concerns that underly the Glass-Steagall

Act against that background. Those concerns were well summarized

in the Supreme Court's opinion in ICI v. Camp, in which the

Court heid that Citibank's merchandising of commingled agency

accounts violated the Glass-Steagall Act. The Court beganby stating that "no provision of banking law suggests that

it is improper for a national bank to pool trust assets, or

to act as a managing agent for individual customers, or to

purchase stock for the account of its customers. But the

union of these powers gives birth to an investment fund whose

activities are of a different character."

Then the Court lists the consequences of that union:

pressures to maximize fees by promoting theinvestment fund service to bank customerswhose needs might be better met by otherinvestments.

pressures to sell new participations to raisecapital to fund redemptions.

impairment of public confidence in the bankthrough the imprudent or unsuccessful opera-tion of the investment fund.

pressures to rescue an ailing fund through"measures inconsistent with sound banking."

pressures to make unsound loans to the companiesin whose securities the fund has invested.

pressures to exploit confidential relationshipswith the bank's credit customers to benefit thefund.

pressures to make the bank's credit more freelyavailable to the fund or to purchase interests inthe fund.

pressures to direct talent and resources fromcommercial banking to the promotion of the fund.

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Many of these concerns are equally applicable to theextraordinarily competitive business of pension fund management.The notion that fiduciary services are offered in a passiveway as an adjunct to an essentially custodial function belongsto a different era. They are sold aggressively, they arewatched closely, the pressures for performance are great andthe bank's name and reputation are deeply involved. Of coursethere are important differences between managing money forinstitutions and managing money for individuals -- althoughthe creation and expansion of Keogh and IRA plans is reducingthese differences. The impact on a bank's reputation fromthe bad performance of a mass-merchandised fund may be fargreater than in the case of a commingled employe~ benefittrust. The question for the Congress is whether thesedifferences are of a kind that suggest that the Glass-SteagallAct should apply in one case and not in ano~her~

What is there about commingling that raises sharplydifferent concerns from pension fund managemen~? What publicpolicy opjectives are served by permitting banks to manageclosed-end, but not open-end funds -- as some suggested afterCamp. A clbsely related issue is now before the Supreme Court.What objectives of the Congress in 1933 are furthered by per-mitting banks to advise open- or closed-end funds, but notto distribute their securities -- a pattern we have seenemerging. The practical result of the current state of thelaw is to deny to individual investors the benefits of pro-fessional money management by banks -- a service that isavailable to institutions and to wealthy investors.

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The growth of pension fund management by banks offers a

laboratory for testing some Glass-Steagall concerns in this

area. The Congress can inquire whether the conflicts of

interest have caused problems, whether the Chinese Wall is

secure and whether bank regulators have been able to avoid

threats to bank solvency from investment management activities:

and it can explore the importance of equal regulation.

Surely, the sad experience of many banks with REIT's

in the 1974-75 period is part of that test and it deserves

careful examination. How does that experience bear on these

broader questions? Was the essential difference between the

REIT experience and pension fund management simply the addition

of public investors? Or was it the lack of the kind of

protection afforded to public investors under the Investment

Company Act? How much blame can be ascribed to the close

relationship between REIT investments and the bank's mortgage

lending activities?

In the same fashion, the Congress may inquire into the

implications for this debate of the sponsorship of investment

companies by life insurance companies. They are depositary

institutions of sorts, albeit with long-term liabilities.

Like banks, they manage vast amounts of pension assets.

What danger does managing commingled funds for individuals pre-

sent to banks that it does not present to insurance companies?

Competitive considerations also deserve attention. It

is likely that if banks are permitted to offer commingled

agency accounts, or to act as investment adviser or distri-

butor for open- and closed-end Iunds, there will be a loss of

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market share to the panks. Some observers think that compe-tition with banks is inherently unfair, that there is animplicit tying arrangement in most business relationshipswith a bank because of the overwhelming importance of credit.

While that issue cannot be quantified, it can be studied.The Fe~eral Reserve staff conducted such a study in the areaof bank insurance services. Banks have made significant

'/'r"" .LncuzsLons into mortgage banking and finance companies, andthe fairness of the competition in those industries can beexaminep. In pension management itself, there is s~rongcompetition among ban~~., insuranc~ companies and independentadvisers •. The independent advisers have made gains in market. . \

share in spite of the fact that pension fund managementis an area where one would thin~ that a bank's lending rela-tionship ~ith the employer would b~ of special significance.Nevertheles~, some observ~rs beiieve that the high performanceof independent advis~rs would.have suggested an even greatershift.

On the other hand, in the case of mass-merchandisedfunds, the conventional wisdom holds that securities aresold, and not bought, and the distribution capacity of themutual ,fund industry may be a real advantage. Moreover, theCongress might want to require that any bank expansion intothis area take some form of extension of service rather thanacquisition in order to increase competition.

Finally, the objective of equal r~gulation deserves thesame attention. I cannot emphasize too strongly that the

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same chahges in the market that indicate a reconsideration

of the market divisions effected by the Glass-Steagall Act

also suggest a reexamination of the rest of the regulatory

framework. The perfectly level playing field is a chimera.

We ~hould not waste our time seeking it. At the same time,

neither investors nor intermediaries are served by material

avoidable differences in the regulatory ground rules.

In general, the Investment Company Act and the Investment

Advisers Act should apply to bank investment management. Why

should an independent investment manager who manages funds for

pension funds and other institutions be regulated by the SEC

as an investment adviser while a bank is not? Why should

they be subject to different rules regarding their ability

to advertise or their fiduciary obligations?

If banks are managing an entity that is the functional

equivalent of a mutual fund or a closed-end investment company

there is no reason to have different rules regarding self-

dealing, pricing, approval of investment management fees,

and the like. The need for independent directors is as

great as in a mutual fund complex. This is not simply a

matter of competitive equity. The regulatory pattern for

investment management is essentially sound., It responds to

real problems that were rife in the investment company industryin the 1920's and were replicated in the REIT experience of

the 1970s. Its logic and benefits are no less applicable to

banks than to other investment managers.

Moreover, it is not clear to me that all of the past

regulatory compromises regarding the Securities Act of 1933

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continue to make a lot of sense. In those plans in which theemployee has an investment decision to make, the resultlooks very much like an investment company. Whether or notany of the employee's money is invested in the employer'ssecurities would seem to have little to do with what oughtto be the result in terms of disclosure.

* * * *These are not easy questions. But the process of

answering them will inform all of us. It is an importantfirst step toward making the regulatory system a consciousinstrument of current policy toward the financial markets.

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